China Is in a Vise

The Shanghai Stock Exchange Composite Index was down 3.27% yesterday. It is 25% below its highest level of this year and more than 62% lower than five years ago. The Hang Seng Index in Hong Kong was down 1.44% yesterday, 27% from its highs earlier this year, and 45% lower than five years ago.

Economic activity is slowing, real estate prices are falling, bankruptcies are rising. And it is happening very quickly. Earlier this year the Chinese government was concerned about a real estate bubble and inflation. To slow both, the government has been making bank loans more expensive and more difficult to access ... until today.

Today the Chinese reversed course again and lowered bank reserve requirements by 50 basis points. It was a very small first move but it is an indication that the government is now more concerned about a slowing export and domestic economy than about inflation and real estate bubbles.

There is good reason for China to be concerned about a slowing economy, too. Its largest export market, the EU, is also slowing and in the nascent stages of a recession that will play out during 2012.

But a big problem is brewing. Even as China has been slowing with the rest of the world, oil prices have been climbing and are back over $100 a barrel.

Lowering bank reserve requirements lets banks make more loans and implies that they will make them. An increase in lending activity in China will cause economic activity to increase but will also cause an increase in demand for and consumption of natural resources and fossil fuels -- especially oil.

Oil trades in a global market, and marginal pricing for the world increasingly is determined by Chinese demand. Oil is also fundamental to all global economic activity. So oil price increases permeate the prices of all goods at all levels, from raw material through the manufacturing process to the cost of transporting the end product to the consumer.

Oil production is already near its peak; there is no slack in global production levels that would allow refined oil supply to increase to meet new demand. An increase in demand for oil coming from China will cause the price to increase globally and force countries and consumers of lesser financial means to consume less so China can consume more. But higher oil prices (driven by China's consumption) will cause the cost of Chinese exports to increase and reduce the manufacturing advantage China has been able to exploit for the past 30 years.

As a result, China is actually accelerating the rate of diminishment of its primary economic advantage by taking this route.

Multiple cascading issues are generated by this process as well. In September I wrote about <a href="http://realmoney.thestreet.com/articles/09/27/2011/u.s.-fdi-china-slowing"> the slowing rate of foreign direct investment into China. In October there was a net outflow of foreign funds from China for the first time in five years.

Foreign direct investment is the backbone of the Chinese economy. China does not have the domestic wealth or consumption to support itself without foreign capital flowing in. As the capital advantage to manufacturing in China is increasingly offset by rising oil and capital costs there, foreign investors will seek out other opportunities -- and they already are.

China is now caught between the proverbial rock and a hard place of its own making. It concentrated almost exclusively on facilitating an export economy to the detriment of on increasing domestic activity and consumption.

With oil prices rising, China is at risk of having to deal with an exodus of foreign capital. Traditionally it has handled such issues by reducing the rate at which capital can be removed from the country ... which, of course, causes capital to attempt to flee even more.

I'll write more about this troublesome situation soon. For now, just be aware of it.

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